The Capital Asset Pricing Model (CAPM) is a financial theory that establishes a linear relationship between the expected return of an asset and its systematic risk, measured by beta (). According to the CAPM, the expected return of an asset can be calculated using the formula:
where:
The model assumes that investors hold diversified portfolios and that the market is efficient, meaning that all available information is reflected in asset prices. CAPM is widely used in finance for estimating the cost of equity and for making investment decisions, as it provides a baseline for evaluating the performance of an asset relative to its risk. However, it has its limitations, including assumptions about market efficiency and investor behavior that may not hold true in real-world scenarios.
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